Why oil could go to $60: as the world teeters on the precipice of another crisis, it's time for a contingency plan

International Economy, The, Fall, 2004 by Philip K. Verleger, Jr.

The rise in energy prices after the successful invasion of Iraq has focused attention once again on energy markets. A year after the military effort that many experts believed would bring crude prices down (including Wall Street Journal editors, who predicted prices would halve (1)), crude oil prices were 56 percent higher than at the end of the war, while regular retail gasoline prices, which averaged $1.86 per gallon during the summer of 2004, were 28 percent higher than a year earlier. At the end of August 2004, crude oil prices were 32 percent higher than at their peak during the market chaos that preceded the Iraq invasion. This market behavior stands in marked contrast to the price response following Iraq's 1990 invasion of Kuwait and the subsequent Gulf War (see Table 1).

The rise in oil prices has been propelled by the inexorable increase in the "far forward price of crude" following the end of formal hostilities in Iraq. Between May 19, 2003--the day President Bush declared "mission accomplished" from the deck of the USS Abraham Lincoln--and August 19, 2004, the price quoted for oil delivered in December 2009 rose from $23.92 per barrel to $36, a 50 percent increase. During this 14-month period, the increase was unrelenting (Figure 1).

[FIGURE 1 OMITTED]

This rise in forward prices was matched by increases in prices bid for high-quality equity units offering investors a return directly linked to oil prices. Share prices offered for the BP Prudhoe Bay Royalty Trust, a trust issued by British Petroleum for production from Prudhoe Bay in Alaska, rose from $14 per share in May 2004 to almost $40 per share. The increase in the BP share price corresponds to a change in investor expectations regarding the rate of increase in future oil prices. In May 2003, investors anticipated that prices would rise at a modest 2 percent, reaching $33 per barrel by 2010. Fifteen months later, the expected rate of increase had risen to 5.5 percent, and investors now expect that prices will reach $55 per barrel by 2010 (see Table 2).

Six reasons can be cited for the rapidly changing view regarding the global energy situation:

* First, China and India have emerged on the global energy scene as major buyers just as they have begun to make a mark on the global economic scene. Increased industrial output and a more affluent citizenry in these countries have boosted energy demand, particularly for petroleum, at record rates in both countries.

* Second, the key players in the global energy industry--both OPEC nationals and the large multinational companies--did not anticipate the demand growth and have failed to expand capacity at an adequate rate. Investment slowed or stopped following the price collapse at the end of last century and companies have been reluctant to accelerate programs since, despite four years of prices that would clearly justify a higher rate of expansion.

* Third, political circumstances in a number of key oil-exporting countries are precarious. There is widespread concern over internally or externally led political disruptions that could result in a significant loss of oil supply or some other energy source for a prolonged period.

* Fourth, investment in processing and transportation capacity--particularly refineries--has been neglected in the United States and Europe. Decisions by competition regulators on both sides of the Atlantic have caused key assets to be transferred from large multinational corporations to smaller firms that lack the financial resources to expand rapidly.

* Fifth, environmental regulations adopted in the United States and Europe have reduced capacity to manufacture key transportation fuels such as gasoline, diesel fuel, and jet fuel. Limited supplies of these products have led to large product price increases, which have pulled up crude prices.

* Sixth, consumers have been led to believe that price increases experienced over the last few years are due not to the natural forces of supply and demand but rather the actions of the energy industry. This mistaken belief has discouraged conservation, particularly in the automobile sector, and created the foundation for a very large price increase to come.

SCENARIOS FOR WORLD OIL MARKETS AND THE WORLD ECONOMY

The situation in the world oil markets today bears a remarkable similarity to the one observed in the late 1960s. The foundations of the 1973-74 oil crisis and subsequent recession were laid between 1960 and 1970. At that time, economic growth in Europe and Japan stimulated increased oil consumption while surplus productive capacity caused the world's multinational companies to limit investment in production facilities.

The data for the earlier time reveal that global consumption grew at a rate of 7.6 percent per year over the six-year period. However, growth in the more developed areas (primarily the United States and Canada) was a more "sedate" 5 percent. Freeworld consumption in 1971 would have been 14 percent, or five million barrels per day, lower in 1971 than actually recorded had use in all countries expanded at 5 percent rather than the recorded 7.6 percent rate. The difference of five million barrels per day was enough to set the stage for the 1973-74 energy crisis.